What is the disposition effect?

Does this ring a bell? Your shares are tumbling down a slippery slope and your brain is screaming “sell”, but you do nothing.

The disposition effect is the tendency to sell winners too early and ride losers too long. Knowing about this effect is one thing, but applying the courage to fix it may be complex and go against your nature.

Share market investors are not the only ones affected by this thinking trap. Property owners may be reluctant to sell because it may mean realising a loss. In each case, the disposition effect can reduce wealth. In their seminal work on the effect, academics Hersh Shefrin and Meir Statman argued four factors contributed to what may appear to be irrational behaviour – loss aversion, mental accounting, regret aversion and a lack of self-control.

1. The more you have …
One factor that can affect our thinking is the law of diminishing marginal utility. As explained by Alfred Marshall in his 1890 book Principles of Economics, this means that the more you have of something, the less you gain from having more of it. If you have €30,000 and are given €1000, it makes a lot less difference to your situation than if you only had €10,000 and were given the €1000 – even though the amount of money received is exactly the same. And this also means that losing money can hurt more than making equivalent gains.

2. Loss aversion
Furthermore, how people feel about a certain amount of money depends heavily on whether it is less than what they previously had, or represents a gain. Having less in financial terms than a pre-determined reference amount makes people feel much worse than if they have gained on that amount, as this seminal 1991 behavioural economics study by Amos Tversky and Daniel Kahneman explains. The starting amount – or reference point – is crucial to how we feel about subsequent gains and losses.

3. “You can’t handle the truth”Actually realising a loss is not only painful but also involves recognising that a mistake had been made. Shefrin and Statman argue "the regret at having erred may be exacerbated by having to admit the mistake to others (spouse, the IRS)”. Regret is such a strong emotion that it can cause people not to act when they otherwise would.

4. Control yourself
A lack of self-control can also be a contributor to this thinking trap. Although we might know that a losing investment should be sold, it can take a lot of self-control to actually do it. There is not necessarily someone or something forcing this to happen.

Act, don’t over-react
In share markets the disposition effect has persistent consequences: people often hang on to shares that have lost money in the hope that they’ll return to the price they were bought at. Knowing about damaging wealth effects doesn’t mean you’ll have the resolve to break a cycle. But there are tricks that might help tip the balance in your favour.

You may want to consider, for example, the steadying calm of a commitment device. Using these frameworks – such as setting a stop loss in stock market trading where shares are automatically sold once they dip below a certain level, or selling a property if a certain price has been offered – can help offset the worst results of the disposition effect.